Assume, for the sake of argument, you believe the wealthiest Americans are undertaxed. And you are desperately seeking new revenue to pay for your ambitious domestic spending plans. What would you do?
That’s the question many Democratic politicians are wrestling with these days. And they’ve come up with widely different answers: Raise tax rates on ordinary income or limit deductions for the highest-income taxpayers. Raise rates on capital gains. Change the way the US taxes bequests. Tax wealth as well as income. Or even combine these options. The Tax Policy Center will hold a taxing wealth program on Sept. 24. But if you can’t wait, or need a cheat sheet, here is a brief look at some of the leading ideas.
Raise taxes on ordinary income: Bernie Sanders would raise the top federal income tax rate from today’s 37 percent to 52 percent for households making $10 million or more. Rep. Alexandria Ocasio-Cortez (D-NY) would raise the income tax rate on those same households to 70 percent.
Academic research suggests the revenue maximizing rate of the federal income tax is much higher than today’s top rate—perhaps somewhere between 60 percent and about 70 percent. But decades of history have shown that adjusting marginal tax rates has very modest effects on the amount of tax people actually pay. When rates rise, taxpayers seek out tax deductions or exclusions, recategorize income as capital gains that are subject to a much lower rate, or defer income.
No matter where Congress has set the top rate over the past half-century, effective tax rates for the highest income 1 percent stayed in a range of roughly 20 percent to 24 percent. Rate hikes could raise significantly more revenue but only if they are combined with measures to limit tax avoidance, such as eliminating tax preferences—a step Congress has largely been unwilling to take for the past three decades.
Raise capital gains taxes. Capital gains and dividends are now taxed at a top rate of 23.8 percent, much lower than the top rate of 37 percent on ordinary income. And two-thirds of the benefit of the capital gains tax preference goes to those making $1 million or more. So how about just raising the rate?
There are a few problems: First, it won’t raise much money. In part, that’s because only about one-quarter of US corporate stock is held by taxable shareholders, according to research by my Tax Policy Center colleague Steve Rosenthal. More importantly, the more Congress raises taxes on capital gains, the more likely taxable investors will defer tax by hanging on to their investment profits (often until they die, see below). TPC estimates the revenue-maximizing rate on capital gains is about 28 percent, not much higher than today’s rate.
Tax unrealized gains. Since investors can avoid tax simply by not selling assets, Congress could respond by taxing unrealized gains. Taxpayers would calculate the value of their assets each year and pay tax– or claim a loss– on any change from the prior year. This accrual form of taxation is doable, but not simple. As much as half of the wealth held by the rich is in hard-to-value assets, according to NYU law professor David Kamin. In addition, an accrual tax may create cash flow issues for some taxpayers.
A few years ago, my TPC colleague Eric Toder and the American Enterprise Institute’s Alan Viard designed an accrual tax to replace the corporate income tax. And they confronted many of the challenges of taxing unrealized gains.
Reform or replace the estate tax. Investors can avoid capital gains tax entirely by holding on to assets until they die. Not only does the estate tax exclude the first $11 million+ in bequests but heirs also benefit from a feature of the tax code called step-up basis. This allows an heir to avoid tax on any increases in asset values over a decedent’s lifetime. If a share of stock Uncle Harry bought for $10 is worth $100 on the day he dies, his heir would pay capital gains tax only when he sells it and only on any increase in value over $100. Thus, $90 of Harry’s gains never are taxed.
There are two solutions: Congress could end step-up basis and require heirs to pay tax on the entire appreciation of the assets they inherit, when they sell them. Or it could require heirs to pay tax on their inheritance as soon as they receive it. In effect, a bequest would be treated like an asset sale and be immediately taxable. This still raises valuation and liquidity issues (for small business, for example) but they can be resolved.
Wealth tax: It is the least familiar tax, at least in the US, but has generated considerable attention since Elizabeth Warren proposed one. Where an estate or inheritance tax focuses on transfers of assets, and today’s capital gains tax is aimed at income from the increase in the value of assets when they are sold, a wealth tax is imposed annually on the value of the assets themselves.
Because so much wealth is held by a handful of the richest Americans, even a modest tax could—in theory—generate a substantial amount of money—Warren estimates hers would raise about $2.75 trillion over 10 years. But collecting that amount would be difficult. As with capital gains, the levy raises issues about how to value privately held assets and creates incentives for taxpayers to understate and transfer their wealth, or to take advantage of any exemptions Congress is likely to include.
As Democrats are discovering, taxing the rich may be a great talking point for their base. But it is easier said than done.